A Big Win for the Crown - Deemed Trusts Take Priority over Security Interests
It was a big win for the Crown in the recent case of Her Majesty The Queen v. The Toronto-Dominion Bank, 2018 FC 538. Mr. Justice Grammond of the Federal Court of Canada held that a statutory deemed trust for unremitted GST amounts took priority over money received by a bank in payment of a loan secured by a mortgage. In reaching this decision, the Court reviewed the history of the deemed trust provisions in the Income Tax Act (the "ITA") and the Excise Tax Act (the "ETA") and considered the case law relating to the interpretation of these provisions. The Court analysed the bank’s obligations to pay to the Crown the money received by the bank, the bank’s defence as a bona fide purchaser for value, and the policy or fairness arguments raised by the bank. As a consequence of this decision, secured creditors will need to pay attention to these statutory deemed trusts in assessing their lending risk.
- Mr. Weisflock (the "Taxpayer") carried on business as a sole proprietorship. In 2007 and 2008, he collected, but failed to remit goods and services tax ("GST") in the total amount of $67,854 to the Receiver General of Canada.
- In 2010, The Toronto-Dominion Bank (the "Bank") granted the Taxpayer a line of credit and a mortgage, both of which were secured by a registered mortgage over his house. At the time of these loans, the Bank was not aware of the Taxpayer’s unremitted GST amounts.
- In 2011, the Taxpayer sold his house and fully repaid his loans to the Bank out of the proceeds of sale, following which the Bank’s security against his house was discharged.
- In 2013, Canada Revenue Agency ("CRA") issued a demand letter to the Bank seeking repayment of the Taxpayer’s unremitted GST in the amount of $97,327 on the basis of the deemed trust provisions in the ETA.
- In 2015, CRA issued a revised demand letter to the Bank correcting the previous amount claimed to $67,854.
- When the Bank refused to pay the $67,854, the Crown took legal action against the Bank to recover this amount.
- The Court found in favour of the Crown and ordered the Bank to pay the Crown the sum of $67,854, together with pre-judgment interest from the date the cause of action arose (namely, October 28, 2011 when the Bank received the proceeds from the sale of the Taxpayer’s house), plus post-judgment interest and costs.
The Court’s Reasoning
The Court reviewed the history of the deemed trust provisions in the ETA and the ITA. The Court noted that prior to 1997, the legislation merely provided that an employer who deducts or withholds income tax amounts (in the case of the ITA) or a person who collects GST (in the case of the ETA) holds that money in trust for Her Majesty. Following the decision of the Supreme Court of Canada in Royal Bank of Canada vs. Sparrow Electric Corp.  1 SCR 411, the Government announced that it would change the legislation to give absolute priority to deemed trusts over secured creditors. Both the ITA and the ETA were amended to provide that:
- the deemed trust would extend to property acquired after the trust arises; and
- the deemed trust would take priority over the security interests of creditors.
The Court then proceeded to determine whether section 222 of the ETA imposed an obligation on the Bank to repay the Crown the amount of $67,854 that the Bank received from the Taxpayer. The Court found that this amount constituted "proceeds" of the sale of the Taxpayer’s property which was the subject of the deemed trust. This deemed trust covered the Taxpayer’s house, despite the Bank’s mortgage registered on title.
The Bank tried to argue that the deemed trust provision only applied in situations where the proceeds were obtained by the secured creditor as a result of enforcing its security and selling the debtor’s property to repay the loan. The Court rejected this argument and stated at Page 12:
"To summarize, the phrase ‘the proceeds of the property shall be paid to the Receiver General’ in section 222(3) of the ETA encompasses proceeds from the voluntary sale of the tax debtor’s property. Upon such a sale, a tax debtor has an obligation to pay the proceeds to the Receiver General. If the tax debtor fails to do so and pays a secured creditor instead, that creditor has an obligation to repay the money to the Crown."
The Court also rejected the Bank’s defence that the Bank was a bona fide purchaser for value. In the Court’s view, the case law clearly established that secured creditors are not entitled to invoke this defence in the context of the deemed trust under the ETA and the IFA. Based on the decision of the Supreme Court of Canada in First Vancouver Finance v. MRN  2 SCR 720 and on the subsequent cases, the Court stated that the bona fide purchaser for value defence was not available to secured creditors. According to the Court, Parliament had chosen to treat secured creditors differently. The Court made the following comment at Page 17 on the amendments to the legislation:
" . . . the 1998 and 2000 amendments to the ITA and ETA deemed trust provisions are based on the premise that a secured party cannot invoke the bona fide purchaser for value defence when it enforces its security or receives a payment from its debtor. If that defence were available, secured creditors would almost always be able to invoke it to defeat the mechanism of the deemed trust. When a secured creditor receives a payment, it usually gives or has given something of value in exchange, whether the granting of the loan or the discharge of the security when the loan is repaid. Moreover, secured creditors are most often unaware of the existence of a tax debt when they receive a payment. Thus, the bona fide purchaser for value defence is inconsistent with Parliament’s intent."
The Court went on to note that this defence of bona fide purchaser for value remains available to unsecured creditors, such as suppliers, landlords or public utilities, who receive payments from a tax debtor. The Court commented on Page 19:
"The results of this may be that unsecured creditors will often be in a position to be bona fide purchasers for value, whereas secured creditors cannot. At first blush, this might appear absurd, but on closer examination, it may have been a rational decision for Parliament to make. By definition, security interests are meant to provide a very strong inducement to debtors to pay their secured creditors first, before paying unsecured ones, and, in all likelihood, before paying tax debts to the Crown."
The Bank tried to argue that the deemed trust only came into operation upon the occurrence of a crystallization or a triggering event. The Bank took the position that this event occurred when the Crown sent its first demand letter to the Bank in 2013, at which the time the Bank was no longer a secured creditor of the Taxpayer. The Bank’s counsel used the analogy of the deemed trust being a "net" that can only fall over trust property at a specific moment. In rejecting the need for a triggering event, the Court responded at Page 21 that "Parliament crafted a very special net for Her Majesty, one that is permanently triggered or deployed."
Finally, the Bank raised a number of policy or fairness arguments, based on the proposition that the payment received by the Bank from the Taxpayer was, in effect, being expropriated to satisfy the Taxpayer’s debts to the Crown. While acknowledging the principle of protection of private property, the Court said that courts must bow to Parliamentary supremacy. According to the Court, Parliament was fully aware of the consequences of the amendments to the deemed trust provisions on private property and the allocation of financial risk. The Court concluded at Page 23:
"Nevertheless, Parliament made the choice to disregard the proprietary interest in secured creditors and to grant the Crown an absolute priority. I cannot cut down the scope of the legislation in an attempt to bring it in line with the principle of protection of private property without thwarting Parliament’s intent."
The Court acknowledged the argument that the consequences of its interpretation were harsh on secured creditors, especially on loans to individuals as opposed to businesses. However, the Court noted that Parliament had already considered that potential hardship and provided a remedy in section 222(4) of the ETA. This section states that for the purposes of the deemed trust provisions a security interest does not include a "prescribed security interest". The Regulations to the ETA state that a certain portion (set out in the Regulations) of a mortgage over land or a building is a "prescribed security interest" provided that the mortgage is registered before the deemed trust arises. Since Parliament had already considered the potentially harsh consequences of the deemed trust on secured creditors and had drawn a line as to what was exempted, the Court could not draw the line elsewhere.
This case is an important decision that will generate a lot of discussion in the lending and legal community. It serves as a reminder to lenders regarding the importance of considering the effect of statutory deemed trusts on their secured loan transactions. It applies to secured loans, whether the debtor is an individual or a business.
As part of their due diligence process, a lender should specifically ask a prospective debtor whether the debtor is liable for any unremitted amounts under the ITA or the ETA. A lender can also request their prospective debtor to sign the consent forms used by CRA to give the lender access to all of the debtor’s individual tax and business program accounts. However, even if CRA discloses information to the lender with the debtor’s consent, the lender may not necessarily be able to rely on this disclosure because of the "errors and omissions excepted" qualification.
Some lenders insert a provision in their loan commitments that requires the borrower to provide annual evidence regarding the payment of source deductions, HST, and other amounts that could form the basis for a statutory deemed trust. Even if the borrower provides this information to the lender annually, it does not mean that the borrower has paid all of the proper amounts that were actually due and owing according to the applicable legislation.
Some lenders require a semi-annual confirmation of payment of all super priority claims prepared by the borrower’s accountant. While not perfect, this at least causes a degree of external review and due dilligence - provided that the lender follows up and requires this confirmation to happen.
Where the security for the loan is a mortgage in favour of the lender over real property, the lender may be able to obtain some measure of protection by obtaining a lender’s policy of title insurance. Unless the lender had knowledge of the claim for a statutory deemed trust at the time the mortgage was granted, title insurance would normally protect the lender for unremitted tax amounts owed by the mortgagor up to the registration date of the mortgage. For this reason, it is important to determine when the claim for tax arrears arose, because only those claims that were in existence prior to the date of the title insurance policy would be covered.
Unfortunately for the lender, the title insurance coverage ceases when the mortgage loan is repaid. This means that title insurance offers no protection to the lender if CRA makes demand upon a lender seeking repayment of the mortgagor’s unremitted tax amounts after the mortgage has been repaid and discharged.
In conclusion, the onus is clearly on secured creditors to make these inquiries relating to deemed trusts and to assess their lending risk.